Munis: Not Unbreakable Bonds at All

Municipal-bond prices fell Monday as we entered into one of the largest issuance weeks this year. The weakness in the face of increased supply may indicate that there is still a lot of nervousness about the muni market.

Note that, on a historical basis, the supply isn’t all that large.

This week's $4.3 billion in expected sales compares with $14.1 billion sold in the same week last year, according to Thomson Reuters data reported here. Overall, supply of munis this year has been at the lowest it has been since the turn of the century.

Over the weekend, yet another foray was made against muni bond pessimism. Writing in the New York Times, Iris J. Lav claimed that fears of a bond crisis were based on a “profound misunderstanding of the differences between the short- and long-term challenges facing state and local governments, and what these governments can do to address them.”

So what is the proper way to understand muni bonds? Lav, who is a senior adviser to something called the Center on Budget and Policy Priorities, began with the now mandatory mention of the historically low rate of muni defaults. We’ve heard it before: no state has defaulted since the Great Depression, only a handful of cities or counties have defaulted in the last 40 years, the few defaults we get are minor bonds issued by quasi-government entities for things like sewer projects that don’t work out.

This sort of thing either persuades you or it doesn’t. If you think that the future performance of muni bonds will likely follow past performance, then you should probably be buying at every sign of market softness. But we heard this kind of thing about the housing market and highly-rated mortgage securities—until suddenly we stopped hearing it because it was so obviously not true anymore.

Lav’s response is to reply that munis are different from mortgages.

“Some doomsayers liken today’s municipal bond market to the mortgage bond market before it burst. But that’s a false comparison: state and local governments haven’t changed the frequency or quality of bonds issued, as occurred with subprime mortgage bonds,” she writes.

But there’s nothing true about this statement of Lav’s.

It’s just not true that the muni bond market hasn’t expanded rapidly.

The size of muni debt grew from $1.4 trillion in 2000 to something like $2.7 trillion today. That growth really isn’t that much more modest than the growth of home mortgage debt from $6.7 trillion in 2000 to the 2008 peak of $14.6 trillion.

The pace of issuance expanded as well. In 2000, only about $200.9 billion of new muni bonds were issued. By 2007, $424 billion were issued. Last year, $430 billion were issued.

The revenues of the states and local governments didn’t expand at a pace to match the pace of debt accumulation. State and local government revenues expanded from $1.3 trillion in 2000 to just $1.9 trillion in 2008. Each dollar collected by the states in 2000 supported $1.07 of debt. By 2008, that number had grown to $1.26. In short, the states were increasing their leverage during the boom years of the decade.

The situation got even worse following the financial crisis. Tax revenues declined while states refused to reign in spending. As a result, leverage climbed so that by 2009, the last year for which complete data is available, each dollar of revenue was supporting $1.35 of debt.

At the same time, states and cities were piling on unfunded health care and pension fund liabilities. In 2000, just over half the states had fully funded pension liabilities. By 2008, that number had shrunk to just four. A 2010 study by Joshua Rauh of the Kellogg School of Management at Northwestern University argued that states are underfunding pension liabilities to the tune of $3 trillion. More conservative estimates put the under-funding at $700 billion.

Combine the unfunded pension liabilities with the muni debt, and you wind up with much higher leverage. Each dollar of state revenues supports somewhere between $1.70 and $2.85 of indebteness.

It’s very clear that, contrary to Lav’s statement, credit quality in the municipal bond space has seriously deteriorated over the past decade. It was deteriorating before the current financial crisis and the recession—and the deterioration accelerated once the slump began.

Lav argues that the mounting problems with state budgets will heal themselves as the economy recovers. The idea is that a recovering economy will drive up tax revenues and drive down the demand for social services.

This is more wishful thinking than analysis. In the first place, the ongoing problem with joblessness in many states will continue to strain state budgets. Additionally, costs from health care reform will drive up spending. If the economy slips into a double-dip recession or if growth is just much slower than expected, it will be far harder for state budgets to grow their way out of their leverage problems.

There’s also a more technical problem with Lav’s analysis. She seems not to notice that the recent tax revenue drops in state budgets have not taken into account the full decline of housing prices. In fact, property tax receipts were still growing as late as 2009, years after home prices began declining.

The reason for this is that home price declines take years to show up in declining tax receipts due to the lag between market values and assessed values. This provides a bit of a counter-cyclical cushion for states, making property taxes somewhat resilient to economic downturns. The tax receipts do eventually fall, however, when the backward-looking assessments are made and new prices factored into property taxes.

This means that for some period after home prices stop falling—and I’ll note here that the most recent data shows existing home prices down 5 percent year over year—we’ll see likely see falling property tax receipts. Even if we assume a robust economic recovery—a big if—the budget problems of the states won’t be over.

Lav assumes that states will be able to get control of their budgets to assure that bondholders get paid. But this assumption is not one she is entitled to recommend to anyone. We do not know that demand for state and local services will decline dramatically, especially as populations across the US age and new federal programs make cutting spending at the state level very costly. We do not know that states will be able to strike deals with public employees over pensions and benefits—in fact, recent events suggest this will be quite difficult.

What’s more, we don’t know how the broader market will react to an isolated credit event—a default or even a close call by a major issuer. Since so many bond holders consider the debt risk-free and hold it for the technical reason of tax savings, the introduction of realized losses could trigger a broad sell-off. Bond guru Jeff Gundlach thinksthis could send the market gong down by at least 15 to 20 percent.

It may not make sense to fear a muni apocalypse. But it doesn’t make too much more sense to ignore the serious fragilities that have grown up in the muni market. Casting blame on “doomsayers” and turning a blind eye to muni risk will only make the pain worse if the market deteriorates.